Wegelin & Co's Oldrik Verloop and Frank Haeusler show how incorporating active tail-risk management in the portfolio construction process can help prevent painful surprises
The past decade, as many investors know so well, has been very much a roller-coaster ride - a lot of ups and downs arriving back close to where we started. A cursory look at the quarterly returns of the main asset classes for Dutch pension funds from 2007-10 confirms such a ride, with equity returns fluctuating between -22.7% and +16.3%. Fixed income capital allocations were on average higher than equities, yet the variability of returns to equities was far more pronounced, as can be seen in figure 1. The risk contribution, however, appears to be heavily skewed towards equities, despite the capital allocation being diversified across different asset classes.
Across the globe, the investment management industry and investors are starting to acknowledge this dilemma and a new breed of asset allocation is emerging, namely risk parity.
Back in the 1980s, investors constructed their balanced portfolios from a simple mix of large cap equities and government bonds, with a prevailing home bias. During the 1990s, investors acknowledged the potential weaknesses of this approach and took diversification one step further as new investment classes such as commodities, real estate and private equity became more accessible. Additionally, diversification came not only from incorporating new investment ideas, but also from increasing the global reach of the investments. Endowment funds like that for Yale University became pioneers of such techniques.
Many of these US endowments gained worldwide recognition as they survived the 2000-03 bear market unscathed. The results were not repeated during the recent credit crisis. Despite the additional diversification, virtues such as liquidity and transparency are also highly prized.
Considering the strong influence of the equity exposure on traditional asset allocation portfolios and the liquidity constraints of several alternative investments, the question arises: how can one sensibly exploit the merits of diversification to make the roller-coaster ride a little more palatable?
The risk parity approach
Risk parity, or the so-called equal contribution to risk approach, is based on weighting risk, not capital. This is achieved by reducing the exposure to riskier asset classes (such as equities and commodities) and increasing exposure to less risky asset classes (such as bonds) so that each asset class has a similar risk impact on the portfolio. In a portfolio of four asset classes, each asset class should contribute 25% of the risk of the total portfolio. Risk can be expressed using different measures and therefore risk parity can be achieved according to different risk metrics, such as volatility, value at risk or others.
One issue with this approach is that when risk parity is achieved, low-volatility/low-returning assets dominate the portfolio. This often leads to expected growth that is below the minimum acceptable return. By introducing leverage into the portfolio, this ‘return gap' can be filled without upsetting the risk/return relationship of the new equal risk-weighted portfolio. Invariably, this involves leveraging lower volatility assets.
The risks of asset classes and instruments also change, resulting in the need for portfolio rebalancing on a higher frequency than traditional investments (such as traditional balanced type of portfolios). Consequently, the liquidity of the chosen instruments becomes an important consideration.
Merits of a risk parity approach
With risk parity investing, no single asset class dominates the portfolio. Consequently, large drawdowns often associated with capital-weighted portfolios are significantly reduced. Return patterns are stabilised, giving investors a steady return series within a risk-controlled environment.
The three charts in figure 2 depict the behaviour of a traditional portfolio allocating 60% to bonds and 40% to equities, versus a portfolio setting the portfolio weights using a risk parity approach. In both bear markets, the risk parity approach had significantly lower drawdowns than the traditional portfolio, especially when measured relative to the achieved return. During the 2003-06 market rally, a risk parity approach was able to participate in the upward trending market. However, in a strong equity bull market, the realised total risk of a risk parity portfolio can exceed the risk of a typical balanced portfolio and does not necessarily achieve superior returns.
Risk diversification is not enough
When the risks of asset classes themselves change, they can do so quite dramatically - these are the so-called ‘fat-tail events'. Tail risk is often underestimated and can result in large and frequent drawdowns and significant portfolio losses. Wegelin Asset Management takes the risk parity approach one step further and uses a unique multi-dimensional tail-risk management engine. Due to the complex nature of tail risk, the engine uses multiple risk indicators such as volatility, correlation, value at risk, skewness and kurtosis, as well as proprietary risk measures, and aggregates them into a single additional risk indicator. The tail-risk engine then adjusts the risk parity allocation, if necessary, to reduce further the probability of significant drawdowns.
In most market environments the tail-risk engine has little impact. But in more turbulent conditions, it can make a considerable difference. A recent example in the bond market is illustrated in figure 3. Investors fled the German Bund in 2010, putting pressure on the 10-year Bund price.
The distribution of daily returns from 2001-10 for the Wegelin risk parity approach is compared with a traditional 60/40 bond/equity portfolio in figure 4. For comparison purposes, the returns are scaled in such a way that both approaches have the same return over the given period. The returns of Wegelin's approach are mostly found around the mean and are much more concentrated than the traditional ‘balanced' portfolio. The advantage of a risk parity approach with active tail-risk management is that investors make small and mostly positive returns, while minimising the extreme negative (left fat tail) events.
Drawbacks of a risk parity approach
A risk parity approach manages and controls the absolute risk of a portfolio. It does not, unfortunately, control the absolute returns - that would be the Holy Grail! Many risk parity approaches are long-only strategies and if several asset classes and underlying instruments exhibit negative performance at the same time, a long-only strategy will not be able to counter market forces. However, by including tail-risk management, it is expected to reduce drawdowns significantly.
Another component that has been criticised is the use of leverage. Many risk parity strategies are implemented with futures, whereby the leverage is solely used to increase the notional leverage of the exposure - in other words, it is not used as a return driver or for lending. The leverage depends on the risk appetite only and is scalable.
The current low bond yield and possible looming inflation environment both pose additional challenges. History (extensive back-testing and theory) has taught us that risk parity profits from the long-term risk premia in asset classes. As long as the limited upside potential in the fixed income market is compensated by other asset classes such as equities or commodities, low bond yields or inflation do not automatically mean losses. However, if we are heading for stagflation, risk parity strategies will face difficult times.
Asset allocation methodologies continue to evolve. For many years the cornerstone of asset allocation was diversifying across different asset classes according to capital. Risk parity turns that concept on its head with risk allocation now driving capital allocation.
Pension funds are long-term investors and are able to absorb market turbulence more than most. However, they too are becoming more interested in how they can better manage their way through periods of extreme price volatility. Risk parity offers a new way to engineer better risk/return trade-offs, better manage downside risk and take advantage of traditional asset classes in a non-traditional way. By reducing the risk concentration away from any single asset class, both the level and the consistency of returns should improve.
Furthermore, to answer certain criticisms of risk parity - uncontrolled leverage, extreme left tail events, and so on - it is vital to incorporate active tail-risk management in the portfolio construction process to capture those unwanted and painful surprises.
Oldrik Verloop is head of Benelux institutional clients and Frank Haeusler is head of portfolio management at Wegelin & Co in Switzerland.